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What Are REITs and How Do They Work?

A Real Estate Investment Trust, or REIT, is a company that owns and operates income-producing real estate properties. REITs allow people to invest in real estate without having to buy an actual building or piece of land themselves. Instead, you can purchase shares of a REIT, similar to buying stock in any other company.

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REITs were created by Congress in 1960 to give ordinary investors a way to participate in large-scale real estate investments. Before REITs existed, only wealthy people or large institutions could afford to own significant real estate portfolios. Today, according to the National Association of Real Estate Investment Trusts (NAREIT), there are approximately 225 publicly traded REITs in the United States, with a combined market capitalization exceeding $4 trillion.

When you own shares in a REIT, you own a small piece of many different properties. These properties generate income through rent payments from tenants or through sales and leasing activities. By law, REITs must distribute at least 90% of their taxable income to shareholders in the form of dividends. This requirement makes REITs different from regular stocks, which may or may not pay dividends.

REITs typically specialize in specific property types. Some focus on apartment buildings, while others concentrate on office buildings, shopping centers, warehouses, hotels, or healthcare facilities like nursing homes and medical office buildings. There are also REITs that own diversified portfolios across multiple property types. This specialization allows investors to choose REITs that match their investment interests.

Practical Takeaway: Understanding the basic structure of REITs helps you recognize that REIT investing is fundamentally different from real estate ownership. You're buying shares in a company, not owning property directly. This difference affects how taxes work, how you make money, and how much control you have over the investment.

Different Types of REITs and Property Sectors

REITs come in several varieties, each focusing on different types of real estate. Learning about these categories helps you understand the range of property types that REITs manage and the different income streams they represent.

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Residential REITs own apartment complexes, single-family rental homes, and other housing properties. According to the Urban Land Institute, residential REITs represent a significant portion of the REIT market. These REITs generate income from rental payments made by residents. The residential sector includes both traditional apartment buildings in urban areas and communities designed for specific populations, such as active adults over 55 years old.

Commercial office REITs own office buildings and office parks. Tenants in these properties include law firms, accounting companies, technology firms, and other businesses. The office sector has experienced significant changes in recent years due to the shift toward remote work. Many office REITs have had to adapt their properties, offering more flexible lease terms and updated amenities to attract tenants.

Retail REITs own shopping centers, malls, and other retail properties. These REITs collect rent from department stores, specialty retailers, and other commercial businesses. The retail sector has faced challenges as more consumers shop online, but many retail REITs have adapted by including entertainment venues, restaurants, and service businesses in their properties.

Industrial and logistics REITs own warehouses, distribution centers, and fulfillment facilities. The growth of e-commerce has dramatically increased demand for these properties. Data from CBRE shows that industrial property rents have grown significantly over the past decade as companies need more space to store and distribute goods ordered online.

Healthcare REITs own medical office buildings, hospitals, nursing homes, and assisted living facilities. These properties generate income from healthcare providers and senior living communities. The aging population in the United States has increased demand for healthcare real estate.

Specialty REITs own unique property types such as cell towers, data centers, casinos, movie theaters, and golf courses. These REITs focus on properties that don't fit into the traditional categories mentioned above.

Practical Takeaway: Different REIT sectors perform differently depending on economic conditions and market trends. Before considering a REIT investment, research what types of properties the REIT owns and whether those property types match economic conditions. For example, if online shopping is growing, industrial REITs may see stronger performance than retail REITs.

How REIT Dividends and Income Distribution Work

One of the defining characteristics of REITs is their requirement to distribute most of their income to shareholders. This income distribution is a major reason many investors study REITs. Understanding how dividends work helps you understand the financial returns REITs can provide.

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REITs must distribute at least 90% of their taxable income to shareholders as dividends. This legal requirement, established by the Internal Revenue Code, sets REITs apart from most other types of companies. Regular corporations can choose to reinvest profits back into the business or pay dividends to shareholders. REITs have much less flexibility—they must pay out most earnings.

Dividend payments are typically distributed quarterly, meaning shareholders receive four payments per year. Some REITs also pay monthly dividends, giving investors more frequent income. The dividend yield of a REIT refers to the annual dividend payment divided by the current share price, expressed as a percentage. For example, if a REIT's annual dividend is $2 per share and the share price is $40, the dividend yield would be 5 percent.

The income that funds these dividends comes from several sources. The primary source is rental income collected from tenants. A REIT's commercial office properties, for instance, generate income from the monthly rent paid by the law firms, consulting companies, and other businesses that lease space. The second source is gains from property sales. When a REIT sells a property for more than it paid for it, that profit can be distributed to shareholders. A third source is fees from management services or other business operations.

It's important to note that REIT dividends are often taxed differently than stock dividends from regular corporations. Most REIT dividends are taxed as ordinary income rather than qualified dividends, which means they may be taxed at higher rates. Tax treatment depends on your individual situation and is something to discuss with a tax professional if you're considering REIT investments.

Practical Takeaway: The high dividend yields that some REITs offer can be attractive for income-focused investors, but remember that dividends alone don't determine investment quality. A very high dividend yield might indicate that the REIT is paying out more than it's earning, which may not be sustainable long-term. Always examine whether the dividend appears reasonable based on the REIT's actual earnings and property performance.

Key Factors to Consider When Evaluating REITs

Evaluating a REIT involves looking at several financial metrics and operational characteristics. Learning about these factors helps you understand what information is important when considering whether to learn more about a particular REIT.

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Funds From Operations, known as FFO, is a metric widely used in the REIT industry. FFO is calculated by taking net income and adding back depreciation and amortization, then subtracting gains from property sales. Many REIT analysts believe FFO provides a more realistic picture of a REIT's cash-generating ability than traditional net income figures, since real estate properties often appreciate in value over time rather than depreciate.

Occupancy rate measures what percentage of a REIT's available space is leased to tenants. A residential REIT might report that 95% of its apartment units are occupied, while an office REIT might report 85% occupancy. Higher occupancy rates generally indicate that a REIT is successfully leasing its properties, though the appropriate occupancy rate varies by property type and market conditions.

Debt levels matter significantly for REITs. Since REITs own expensive assets, they often use borrowed money to finance property purchases. The debt-to-total capitalization ratio and loan-to-value ratios tell you how much debt a REIT is carrying relative to its assets and equity. A REIT with very high debt levels faces greater risk if interest rates rise or property values decline. However, some debt can be healthy, as it allows REITs to grow their portfolios.

Rent growth trends show whether a REIT is able to increase the rents it charges to tenants over time. If a REIT operates in a market where demand for space is growing faster than new supply, rents may increase, benefiting the REIT.